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Abnormally high clearance activity in the women's apparel department undermined J.C. Penney's profitability last quarter. Should investors be concerned?

J.C. Penney (NYSE:JCP) stock plunged 15% on Friday, after the company significantly reduced its third-quarter and annual forecasts. In total, J.C. Penney reduced the midpoint of its fiscal year 2017 earnings per share guidance by 90%. This news dragged down shares of Kohl's(NYSE:KSS) and Macy's(NYSE:M), which fell 5% and 8%, respectively.

The guidance cut confirmed that J.C. Penney continued to struggle during the third quarter. It also casts doubt on management's forecasting ability, which is obviously relevant for managing the business. On the other hand, the news wasn't as bad as it may have seemed -- and it wasn't really relevant to Kohl's and Macy's whatsoever.

Pulling down the guidance

As of August, J.C. Penney's formal guidance called for full-year comp store sales to be between down 1% and up 1%, gross margin deterioration of 0.3 percentage points to 0.5 percentage points, and adjusted EPS of $0.40 to $0.65.

On Friday, it scrapped multiple aspects of that forecast. J.C. Penney now expects full-year comp store sales to be flat to down 1%, gross margin to decline by 1 percentage point to 1.2 percentage points, and adjusted EPS of $0.02 to $0.08.

For the third quarter, the company is on track to record a loss of $0.40 to $0.45 per share: more than twice as large as what analysts were expecting (on average). Comp sales likely increased 0.6% to 0.8%, but gross margin fell by at least 3 percentage points on a year-over-year basis, as J.C. Penney accelerated the liquidation of slow-selling women's apparel inventory.

Assessing J.C. Penney's results

Various news outlets picked up on the reduction in J.C. Penney's comp sales guidance, implying that the company's sales trends are getting worse. That's not quite accurate, though.

While J.C. Penney did reduce the high end of its full-year comp sales guidance, analysts have been expecting that for months. Given that comp sales fell by 2.4% in the first half of the year, posting comp sales growth on a full-year basis would have been extremely challenging.

In the third quarter, comp sales returned to growth. The clearance sales in the women's apparel department definitely contributed to the 0.6% to 0.8% expected increase, but any kind of growth is notable in the current environment. Moreover, the new guidance for full-year comp sales to be flat to down 1% implies that comp sales will rise by about 0% to 3% in the fourth quarter.

As for J.C. Penney's gross margin woes, management has highlighted the company's need to retool its women's apparel business for nearly a year. J.C. Penney has had a heavy focus on traditional work attire, but consumers are more interested in casual styles and activewear right now. The transition to a new women's apparel assortment should put J.C. Penney in position to post better results -- but it was a lot more painful than expected.

What does it mean for competitors?

J.C. Penney's quarter-long clearance sale on women's apparel may have pulled some traffic away from rivals like Kohl's and Macy's. However, given that J.C. Penney was primarily clearing out less-desirable inventory, the impact shouldn't be overstated.

On the flip side, J.C. Penney's underlying comp sales performance was much better than what it posted in the first half of the year. Furthermore, its gross margin weakness was almost entirely driven by company-specific factors -- namely the elevated clearance activity in women's apparel and the company's push into the lower-margin appliance business.

Management needs to regain its credibility

After teetering on the edge of bankruptcy in 2013, J.C. Penney was able to show fairly consistent progress in stabilizing its sales, improving its profitability, and paying down debt between 2014 and 2016. The performance improvements earned it numerous credit rating upgrades.

In 2017, J.C. Penney's management has squandered the credibility it built up over the prior three years. After all, this isn't the company's first guidance mishap of the year. It also posted weak gross margin results in the second quarter, related to inventory liquidation in the nearly 140 stores that J.C. Penney closed in late July. A month before that earnings report, CEO Marvin Ellison said in a press release that J.C. Penney was on track to post improved sales results -- without mentioning the gross margin shortfall.

Thus, it appears that management isn't being completely honest about the near-term challenges J.C. Penney faces. Alternatively, the company's leadership has very poor forecasting skills. Neither scenario should be comforting to investors.

The only solution to this credibility gap is for management to start providing realistic forecasts -- and then hit those targets consistently. Now that J.C. Penney has cleaned up its inventory and jettisoned its lower-performing locations, we'll see if it can get back on track in 2018.

Author

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry! Follow @AdamLLW